One of the things I realized as I age is that the best pieces of advice are always simple, but not easy. There are always some cases in which some of the advice might not work, but for most people, the advice holds. Here are some examples:
To lose weight – consume fewer calories than you expend. Or, eat less, exercise more.
To become financially independent – pay yourself first, or save more than you spend.
To meet your soulmate (or make friends) – leave the house and interact with people.
Of course, all of this is easier said than done. It’s hard to interact with people if you have anxiety. It’s difficult to save when spending is so much easier and more fun. And I truly believe that anyone who claims to love exercising is lying.
Which is why a lot of the advice out there is simple, but not easy. This could end up with the unfortunate side effect of making us lose hope. But there are some genuine things that can help us on our journeys, especially when things seem hopeless.
For example, GLP-1s can help many people lose weight. In-person events can help people connect. And the power of compounding can help you save more efficiently.
What is compounding?
We’ve talked about compounding before. There is a quote that is often attributed to Albert Einstein, that says something like, “Compound interest is the eighth wonder of the world. If you understand it, you earn it. If you don’t, you pay it.”
I am not entirely sure he said it in that way, but there is truth to it. Compounding, or compound interest, is the interest you earn on the money you have, AND on the interest it has already earned. It basically is what happens when your money starts making money. We talked a little bit about this when we reviewed “The Richest Man in Babylon.”
Here is the problem. Investing your money in one place, and then forgetting about it, and letting it compound is simple advice. But it is not easy. I know I should not be fretting about my portfolio, but every time the market crashes, I have the urge to check my RRSP and sell the securities that are underperforming.
That’s why I want to approach compounding in a different way today. It is simple math that if you let your money grow, you’ll end up with more of it. But psychologically, it’s hard to do. So, let’s look for some ways to mitigate this problem.
Exponential growth bias is at play
In 2008, Victor Stango and Jonathan Zinman published a paper called Exponential Growth Bias and Household Finance. In it, they explain that exponential growth bias is the pervasive tendency to linearize exponential functions when assessing them intuitively. What this means is that it is really hard for us to estimate how much growth (or loss) can occur over a long period of time.
What the researchers concluded is, “On the borrowing side, exponential growth bias generates payment/interest bias, which causes consumers to systematically underestimate interest rates on short-term (but not long-term) loans. On the saving side, exponential growth bias generates future value bias, which causes consumers to systematically underestimate the benefits of long-term saving.”
Let me explain this another way. Earlier this year, I reviewed The Psychology of Money. Here’s how Morgan Housel explains it, “Linear thinking is so much more intuitive than exponential thinking. If I ask you to calculate 8+8+8+8+8+8+8+8+8 in your head, you can do it in a few seconds (it’s 72). If I ask you to calculate 8×8×8×8×8×8×8×8×8, your head will explode (it’s 134,217,728).”
So, it’s easier for us to understand simple interest, but compound interest is harder. Housel also offers another example – most of Warren Buffett’s wealth accumulated after he was 50. He started investing when he was 10. He was able to allow his money to compound, uninterrupted, for decades.
How to “win” compounding
It might feel like it is impossible to overcome your brain and make compounding work for you. That’s not true. Warren Buffet did it, and so can you. The key is to not rely on willpower to make it work. Instead, remove friction as much as possible.
Tip 1: Make investing default
My best friend in my investment journey was auto deposit. I automated transfers into my RRSP and TFSA with every paycheck. Once I automated it, it became default for that money to be removed. I learnt to live without it, and my portfolio kept growing.
Tip 2: Grow savings with raises
Lifestyle creep is a real thing – the more we earn, the more we spend. I have a rule. Each time I get a raise, I increase my saving proportionally. That way, not only is my lifestyle growing, but my savings are too.
Tip 3: Make it harder to withdraw
For my TFSA and RRSP, I choose to use banks where I don’t have the apps automatically open on my phone or browser. I also have two step authentication, and other pauses on immediate withdrawals. That means that if I want to withdraw from these important accounts, I need to overcome friction. Oftentimes, unless I absolutely need to do it, I’d rather not deal with the hassle.
Tip 4: Check less
The less I check my accounts, the less I have the urge to do something. I have alarms set for twice a year, when I dedicatedly check my portfolio and rebalance when required. The rest of the time, I leave it and forget it.
Simple, Not Easy
Compounding is simple, but it is not easy. Yet, it does not have to be hard. What I did to make it easier on myself was to remove friction to invest and increase friction to withdraw. That way, I can trick my brain into making the right money decision for myself. And so can you!
